Is the old Gillian Tett back? The one-time Financial Times capital market editor has taken to writing less frequently (understandable now that she has head the US operation) and less intrepidly (much of her commentary was prescient, particularly on my pet topic, collateralized debt obligations).

But her latest piece sounds a wee warning, and it’s one we’ve commented on as well, namely, that central banks are vulnerable to losses, and just like the banks they mind, may need a rescue by taxpayers if the err badly enough.

Her object lesson is the Swiss National Bank. Unlike most central banks, the SNB is quite transparent, and publishes periodic statements of the value of its assets on a mark to market basis. The usually conservative SNB made a uncharacteristically aggressive move last year, intervening in currency markets in an effort to suppress the value of its levitating franc.

Even though the locals applauded the move, the central bank was outgunned by currency traders and threw in the towel mid year. As the swissie continued to rise, the bank showed losses at the end of 2010 of SFr 21 billion. The only saving grace was that the gains on the bank’s hefty gold positions exceeded the damage. But that does not reassure its shareholders, who have become accustomed to annual payments out of bank “profits”, and are concerned that the profits this year will be too meager for them to enjoy their customary level of income.

The losses at the SNB have come to light partly because it is relatively transparent – and currency swings can be monitored more easily than, say, price moves on bonds. But the SNB is not the only central bank that has recently taken bold gambits. The European Central Bank, for example, holds an (ever-swelling) pile of periphery eurozone bonds; the Fed’s balance sheet has more than doubled in size, to $2,500bn, as it has gobbled up mortgage-backed bonds and Treasuries; and the Bank of England also holds a large pile of gilts and mortgage assets.

Thus far – unlike at the SNB – those experiments have not generated visible losses. A cynic might argue that is because there is less transparency. However, in reality, other central banks have also been canny – or lucky – too. The Fed, for example, acquired its mortgage assets at seemingly low prices, which creates a cushion. Last year the Bank of England saw unexpected gains on its gilt holdings and the ECB has recently enjoyed rising quantities of interest income from its peripheral bonds.

But this happy picture may not last indefinitely. In the coming years, the price of Treasuries or gilts could plunge; some peripheral eurozone bonds could even default, creating losses. If that ever occurred, some central bankers think that any pain could still be offset. The Fed, for example, currently receives so much “income” from seigniorage that it may have considerable room for manoeuvre. But, there again, the Fed already faces virulent domestic political criticism; and at the ECB there is no clear agreement about who would indemnify it in event of losses. It is not impossible to imagine a scenario, then, where losses might stir up a row; particularly if political groups already had an axe to grind – as in Switzerland.

I believe Tett has underestimated the magnitude of the potential problem. First, the Fed’s program of mortgage-backed securities and other bond purchases have high odds of losses. The big risk is not credit losses but interest rate losses. The Fed bought bonds when yields were at rock bottom levels. The game plan is to unwind positions when interest rates are higher, to sop up liquidity. HIgher interest rates mean lower bond prices. If the Fed succeeds in getting the economy back to a normal level of inflation (which is one of its aims, it means it will suffer losses on anything other than very short dated paper.

….it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk. Without a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

Notice that the Fed has quietly established an accounting finesse to circumvent this outcome. Normally, the Fed remits funds to the Treasury annually. The notion is that any Fed position losses (due to credit losses or adverse interest rate movements) would be credited against income earned on Fed assets. If that number still was negative, it would have a credit at the Treasury. In the next profitable year, the Fed would simply retain some of the income it would normally forward to the Treasury to recapitalize the loss. This is what we call “extend and pretend” when private sector banks use flattering accounting to mask balance sheet holes and hope they can earn their way out of trouble.

Now some readers will contend the Fed is highly unlikely to need to revert to this mechanism, much the less to run into an actual negative balance. I’m still troubled. The officialdom has become positively self congratulatory about its conduct during the crisis (even though Geithner is getting the limelight at the moment, the media fawning is unseemly). It not only bailed out the official banking system, but it also rescued the shadow banking system. The Fed and other central banks have made it clear that they will not let either major institutions or markets they deem to be significant fail (note that pure retail markets, like auction rate securities, don’t count).

And the dirty secret of the ongoing Eurozone mess is that its banking system has not been cleaned up, and many countries (England, Germany, Switzerland, the Netherlands, for starters) have banking sectors so large relative to the size of their economies that their central banks cannot effectively backstop them. That should mean that the first order of business ought to be to constrain credit growth to increase the safety and stability of the system. But that’s a no-no. We’ve had various financial reform efforts that leave the system still significantly unfettered, when the size and danger it poses says it should be shackled. And the other mechanism for reducing risk, which is to increase capital in the banking system, is being approached in such a cautious and half hearted manner so as to assure it will fall well short of what is needed (witness the attenuated timetable for implementing Basel III).

The Fed unfortunately appears to believe its PR. It seems to think that financial reform measures like living wills and special resolution will work, when they have two fatal flaws: nation based bankruptcy regimes and the unwillingness of counterparties to have positions frozen while a firm is unwound. But the financial firms understand this little scheme won’t work even if the regulators have persuaded themselves that it will.

The failure to change incentives of executives and producers, or restrain risk taking in a significant way, means the industry has been merely inconvenienced after having had cdentral banks demonstrate that they will pull out all stops to save major players. This simply encourages the financial services industry to engage in a large scale martingale betting strategy. Per Wikipedia:

The simplest of these strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails. The strategy had the gambler double his bet after every loss, so that the first win would recover all previous losses plus win a profit equal to the original stake. Since a gambler with infinite wealth will, almost surely, eventually flip heads, the Martingale betting strategy was seen as a sure thing by those who advocated it. Of course, none of the gamblers in fact possessed infinite wealth, and the exponential growth of the bets would eventually bankrupt those who chose to use the Martingale.

The industry nearly blew itself up, was rescued, and in short order was paying itself even higher bonuses than before the crisis. That means it has every reason to go back to piling on risk. The Fed’s accounting finesse means it has slipped one of the mechanisms, having to deal with the consequences of a loss, that might constrain its behavior and hence make it think more carefully about its balance sheet operations. Incentives matter as much for central bankers as they do for banks themselves, and the one at work for the Fed are poor indeed.

27 comments

“….it is possible that, should the private securities default, the central bank will suffer a capital loss so large that the central bank is incapable of maintaining its solvency on its own without creating central bank money in such quantities that its price stability mandate is at risk.” Willem Buiter via Yves

Not that I would ever wish to help a central bank but it seems to me that leverage restrictions on the banks could compensate for a considerable amount of money printing so as to prevent price inflation.

“The Fed can “print” its way out of balance sheet losses only to the extent that it is not constrained by inflation. If it does run into inflationary constraints, it would need an explicit bailout, irrespective of the accounting treatment.”

I do not buy into this. Nor do I buy into the argument that a central bank is indded a bank.

The so-called “price stability mandate” is already massively gamed. Noone who eats and care for the health of their family on an average paysheet will ever believe.

Of course not everyone live in an Arabic state on 2$ per day. If you are a single living in an OECDE country, just look fairly at prices for a start. And not only the ones of electronic junk purchases that still benefit from massive technology-and-or-productivity gains.

The inflation figures can and will be gamed à la chinoise in the coming years. At will. Of course it takes time to destroy an initialy sound currency system à la Volcker. But that can be done and will be done.

The way the money printing is organized and sold out to the masses within the banking system is a pure political shill. One should admit that Bernanke is especially brilliant at this perverse game.

You are showing your age or more accurately, the lack thereof. I guarantee you are younger than 40, probably younger than 35.

You have it wrong. The Fed cares very much about “core” inflation, ex oil and food. And central banks have had a serious anti inflation bias right now. They may underestimate their ability to rein in inflation, which is why many think their actions are more reckless than the central bankers think they are, but that is a separate issue.

Once inflation gets above 5% to 6%, it starts wreaking havoc with asset prices, business investment, and capital markets. Take the resulting 7% to 9% for intermediate to long-dated risk free investments, tack on a risk premium, start discounting cash flows and anything of intermediate or long maturity is worth VERY VERY little. Anyone who lived through the stagflationary 1970s will confirm that.

As I have discussed long form in older posts, high inflation also makes it impossible to interpret financial results, since different items inflate at different rates. Managers and investors really can’t tell if a business is making any money (unless it is so grossly profitable or unprofitable as to be beyond any doubt). The resulting effective lack of transparency further discourages investment.

Inflation is a huge tax on capital. Who do central bankers serve? Owners of capital.

Yves said: “Inflation is a huge tax on capital. Who do central bankers serve? Owners of capital.”

If I were one of the sociopathic owners of capital and looking to further my control over society, given recent “earnings” from my capital I could take an inflation loss much easier than the pond scum at the bottom of the economic ladder for quite a while and still be in complete control after the “dead weight” is eliminated from the system.

Inflation is only a tax on capital if you don’t own the underlying governments and have to pay the piper like the rest of the public. IMO, that governments are owned is just one of the facts coming out of 2008 bailouts.

Intriguing Strausssian “strategery” — engineered inflation as a part of the Shock Doctrine. It’s just like the housing bubble itself, “gee, who could’ve known that self-regulation was fatally-flawed. (Well, it was patently obvious, even to many of us without any financial training!)

The financial powers are certainly capable of such treachery, but I suspect it will ultimately backfire with incendiary blowback. The Middle East should stimulate some serious introspection about tempting fate, but their own ominously-expanding bubble of arrogance appears impenetrable. It may well be the last bubble to blow (up).

The bankers are probably well aware of elasticity of supply due to globalization. I can’t think of any single consumer product that can’t be oversupplied if the price is high enough. This is by far not 70s. I agree that printing money will lead to new bubbles, but they are more likely to be in financial markets than in consumer products. IMHO.

PS “Particularly movement of material and goods between and within national boundaries. International trade in manufactured goods increased more than 100 times (from $95 billion to $12 trillion) in the 50 years since 1955″

In the years that just followed ww2, the Fed just sat on the price stability mandate and let inflation go much high than the short term rate. It was evidently part of the Fed-Treasury accord and was made necessary by the great amount of public debt accumulated during the conflict.
No need to fiddle with the CPI, it will be done in plain sight as it is indeed the plan.

GDP fell by nearly 9% in 1946. There was a great deal of fear the Depression would resume when the war ended. But the fall turned out to be a one year adjustment as employment fell (remember all those women working in factories left when the soldiers came home).

The 1947 inflation spike was brief but politically very controversial, and was the result of strikes, not Fed monetary easing, and may have also gotten a boost from pent up demand hitting an economy that had not retooled from wartime production. And it looks like it was reined in pretty quickly, given the amplitude of the move.

I’ve won a lot of money playing 9-ball against the Martingale. What Martingale advocates don’t realize; your bankroll might seem safe, at say 300, but if you play the first game for 20, you only have four bullets.

When you’re up against a competent player, and you play less than rock solid, I assure you, four bullets is not enough. Not even close.

Of course, if you don’t insist on cash payments after every game, getting involved with a double-or-nothing, air-barrel type character can lead to some pretty meaningless negotiations.

“One more? Double or nothing?”

“What do you owe me?”

“62 thousand.”

“Hmm…that would make it 124 grand. When can you pay me?”

“Next week?”

“Ok, but this is it. Comprende? I’m not playing one game for a quarter-million. That’s too much.”

I have also won a little money playing 9-ball in my youth. Amateurs never see the truth until the end of the evening. The Pros win very few of the early games, win more of the middle games and win all the late games.

Poker is much more instructive. I was a relatively large overall net winner during my time in the Army. I had bad nights, where I could not seem to win a hand, and good nights where I could not seem to lose. Most of the time it was a slog, with small winnings. And that was in a game with theoretically random outcomes for any single game.

Introductory classes on Probabilities and Statistics should be taught by dedicating all the class time to 5 card draw poker games. Statistical improbabilities happen more often than we think.

And applying this doubling the bet strategy to a game which does not provide statistically random results is a formula for disaster.

My experience has been that weak pool players attempting utilizing the Martingale — to take down a vastly superior player — fail to realize that exponential function is doing double duty.

Weak players and gamblers definitely see the exponential function in the wager, that’s the allure, they want to get the better player into that pressure cooker game for 1,280, or 2,560; but they fail to grasp three things, one; they must perform a minor miracle, go 7 or 8 ahead against the vastly superior player, two; the exponential function works incredibly fast in the wallet, a 300 dollar bankroll and four consecutive losses means, 20, 40, 80, 160 and you’re broke, and three, as long as there is an insistence on cash payments after every game, they have no chance. They will never see the 1,280 game.

It’s funny, I never knew that the double-or-nothing attack had a name — the Martingale. Cool name. I like it. I’m going to start using it.

Same with peak oil. The people that study of the interaction of the dueling functions of oil consumption and oil depletion, which in some countries, like Saudi Arabia, are each working against each other at exponential levels (the negative double-exponential function), have given their model a cool name too, which I didn’t know about until recently, the Export Land Model.

“The strategy had the gambler double his bet after every loss, so that the first win would recover all previous losses plus win a profit equal to the original stake. Since a gambler with infinite wealth will, almost surely, eventually flip heads, the Martingale betting strategy was seen as a sure thing by those who advocated it. Of course, none of the gamblers in fact possessed infinite wealth, and the exponential growth of the bets would eventually bankrupt those who chose to use the Martingale.”

That’s all you need to know to disprove the “Harvard economists” proof that banks can’t go bankrupt:

Interesting that you should bring up the Martingale strategy–the SPX has assumed Martingale return characteristics lately, slow and steady rises and sudden sawtooth declines. I attribute this to the put sellers, but who knows?

How many people know that, for instance, central bank of Czech Republic has negative capital? Yet, the country is doing pretty damn well. As long as central bank is a real central bank and not like a crippled one in eurozone, capital is a non-issue. But then Swiss National Bank is really a private central bank. So negative capital is a mirror position of shareholders investment. So now it is clear where the wind is blowing from.

Having worked at the Fed during the Volcker era, let me divide your blog into its two critical elements.

First, how does the Fed account for an underwater Treasury portfolio?

Second, how does the Fed remove all of the reserves it injected into the system to buy its current Treasury portfolio when inflation returns to meet its stable price mandate?

The Fed accounts for its Treasury portfolio using historic cost. If it held all $2+ trillion of the securities that it purchased during the credit crisis to maturity, it would seldom if ever show a loss. The only circumstance would be if one of the securities defaulted or at maturity failed to payback at least the Fed’s purchase price.

Where the losses will most certainly come from is when the Fed tries to extract the reserves it pumped into the banking system to buy the $2+ trillion in securities in the first place.

The challenge will be how to fight inflation and at the same time minimize losses when liquidating the portfolio.

The Fed has a number of tools at its disposal that suggest this can be accomplished. For example, rather than “sell” the Treasury security at a loss, the Fed can repo the security. From the perspective of fighting inflation it has virtually the same impact: withdraws reserves from the system.

The effect of “mopping up” will be to raise short term interest rates as liquidity becomes more dear. This will raise the value of longer term Treasuries as the other asset classes are crushed. So the Fed has no problem.

I think you under-emphasized and Ignim hints at what might be the most interesting point in Gillian Tett’s article: the focus on SNB is “partly because it is relatively transparent”.

The fundamental driver behind the credit crisis has been a lack of transparency. A point you have made countless times.

Here we have an article about the Swiss central bank and there is no link made to the opacity practiced by the US central bank. In order to get some data from the Fed, Mark Pittman and Bloomberg had to file a lawsuit.

As you accurately point out Yves, when central bankers start adopting the flawed strategies of the banks they are suppose to regulate….

Buiter argues for “… a firm guarantee up front that the Federal government will fully re-capitalise the Fed for losses suffered as a result of the Fed’s exposure to private credit risk…”. But where will the Fed government get the capital to perform this wizardry. Well it will issue bonds which the Fed will guarantee.

What is the point really in considering Federal Reserve balance sheet losses. What does the Fed care about whether or not it’s assets are underwater? The Fed doesn’t really have any liabilities. Sure maybe it will have to make good on the excess reserves that banks have deposited. Is that really going to be a problem? The inflation constraint is a constraint on its normal operations. It will force the Fed to raise short term interest rates which will crush the carry trade and long term asset values; except, probably, long term government bonds. QE2 allows the Fed to be completely indifferent to the consequences for the lousier assets its balance sheet.

Wow, are you serious, people use the Martingale to play pool? That is the most retarded thing I have ever heard. Using it for roulette is pretty much the only vaguely sensible application there could be, and you still would want to start very small I think. Plus table maximums are going to make it very difficult to see the big number wins you will probably need at some stage.

jimmy james nails it! A central bank cannot default on its own currency, unless it voluntary chooses to do so. In A. P. Lerner’s words, money is a creature of the state, a natural monopoly if there is one. Let’s imagine a water monopolist with an unlimited supply of water and a marginal cost of production of zero (read: the Fed and the dollar). Could it ever “default” on its water supply? Of course not!

Also, contrary to Buiter’s fears, it would be an excellent thing if the Fed was forced “to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed”. Central bank “independence” gave us decades of low inflation, mediocre growth and high unemployment. Maybe it’s about time to send economic policy making back to where it belongs – to elected, accountable politicians instead of unelected central bank bureaucrats forever stuck in a gold standard mindset.

“…The Fed cares very much about “core” inflation, ex oil and food. And central banks have had a serious anti inflation bias right now. They may underestimate their ability to rein in inflation, which is why many think their actions are more reckless than the central bankers think they are, but that is a separate issue…”

I understand Yves’ concerns with the Fed balance sheet management, Timmay’s SPV, and does the Fed even have credible ability to perform its primary mandate of stable prices (I never believed that the Fed employs people, and stable prices is a stretch as well).

But there is one more wrinkle to consider and that is Ben’s new invention of paying interest on bank reserves held at the Fed. He exudes great confidence that this provides a monetary tether on his freshly created benjamins and that he can yank on if the benjamins ever get feisty enough to exhibit signs of velocity above the maximum speed limit.

Ok, not to worry, Ben or Janet is in charge. There is still the problem that these benjamins don’t die until smitten with a now long dated Treasury or MBS in the Fed’s balance sheet arsenal (and as Yves pointed out, less benjamins are smitten than the face value of a long dated bond would indicate). But, ok.

So how’s that been working for Ben so far? Absolutely swimmingly!

It’s standard procedure for the Fed to turn over any “operating gain” to the Treasury every year. This comes from yield generated on the Fed’s balance sheet less operating expenses (the Fed doesn’t have any of those annoying FX interventions to do like other central banks, so these are low. Few hundred economists, and they couldn’t possibly make much).

Last year Ben gave Timmay $70B. So that’s what the Fed netted from the balance sheet after paying .25% on reserves and internal expenses.

So that’s the total kitty Ben can pay to the banks to persuade them to keep their benjamins at the Fed, whenever the banks decide they have some excessively high inflationary use for them (looking at the core inflation measure the Fed likes to use, you know… chinese stuff inflation). Also, irrational exhuberance be damned. Why take risk when 3% is a sure bet? Risk Off, Risk Off our bankers will shout.

So let the games commence. It’s a whole new one.

Then there is the thing about ZIRP becoming embedded in everyone’s real budget, and also the complex, imaginary plane of financial derivatives. No number of speeches from Ben, Timmay, or whathisname at the OCC will convince me they have the faintest clue about what may happen there as a result of either planned or unplanned uptick in interest rates.

The Ministry of Truth will sternly state Inflation is Deflation, and probably be “right” for once.

Are you throwing us Fed haters a bone here? As the MMT people say, as long you demand tax payments in dollars, dollars will be in demand. That’s the key point.

The fat tail in central banking is if people lose confidence to the point that they ditch all fiat money to buy real goods. As long as the government demands that you trade those goods back into dollars to pay them, the fiat money survives.

The fat tail in government is that everyone decides to not pay taxes and goes grey economy.

The central bank creates money by buying government securities. The government creates a captive market by demanding taxes in the form of central bank notes. Who cares what the balance sheet says?